A lot of digital shops devote a good amount of time to R&D. Working on new code, new products or new processes not directly related to billable client work. Crafting solutions that don’t yet exist…trying, failing and trying some more…promoting a culture of learning and innovation along the lines of Google’s “20 percent time.” If this sounds like your business, Uncle Sam may have something extra for you come tax time.
Research & Experimentation (R&E) Tax Credit
In the early 1980s, the federal government established the Research and Experimentation (R&E) tax credit (commonly called the R&D credit) to incentivize and reward companies for creating, improving or advancing processes or products. At the time, the credit left out a good majority of businesses dedicated to innovation…namely, startups.
With no customers, and thus no profits, startups couldn’t take advantage of the credit at first. But the federal government changed its tune with the PATH Act of 2015, allowing qualified businesses to claim the credit to offset payroll taxes.
So what is the R&D credit, what does it cover and how can you take advantage of it (if you aren’t already)? We turned to our friends at Summit CPA Group for a high-level overview, and tips on how to make the most of it.
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Eligibility for the R&D Tax Credit: Four Criteria
The tax code is written to reward R&D efforts by U.S. businesses paying U.S.-based employees (or contractors). The hardest part of claiming the credit is determining whether or not you have an activity that qualifies under the Code Section 41. Summit CPA Group recommends evaluating your efforts against four criteria.
Ready? Here we go…
1. The activity must attempt to eliminate a technological uncertainty.
- What are you developing, and how is it new or improved?
- Has anyone else done this?
- Is it currently on the market?
- (Most importantly! Going back to the start of the project…) What is the uncertainty that you are trying to clear? What did you not know at the beginning of the project?
- If you already know the answer, then it probably isn’t research.
2. The activity should strive to gain new technical knowledge that is useful in the development of a new or improved “business component.”
(This is a fancy term to define a product, process, computer software, technique, formula or invention to be sold, leased, licensed or used by the client performing the research.)
- What are you developing and is it on the market?
- Can you buy this product or process from someone else?
- What technical challenges were involved in this new process?
3. The research must entail a process of experimentation aimed at the development of a product or process with “a new or improved function, performance or reliability or quality.”
- One needs to explore and evaluate alternatives in the development of a business component that are intended to reduce uncertainty from the first step.
- What were the different alternatives you explored?
- Did you try to purchase an alternative? Why didn’t it work in addressing the uncertainty you documented in Step 1 that made you invest time into another alternative?
4. The activity must seek to discover information that is “technological in nature.”
- This is easy to achieve. Computer Science is labeled as technological in nature in many IRS publications.
Note: Although one may be certain of an end result for a product or process (i.e., the requirements of the software product or use of website, therefore, no uncertainty), one may still qualify for the credit if the method of achieving the end result is uncertain at the beginning of the research activities.
Example: You know what the end result of “Product Z” looks like, and the way to get to “Product Z” (A --> M --> Z). However, you’re uncertain if you can get to “Product Z” via A --> D --> P --> Z, which improves the process. The time invested in researching the new path can qualify.
Tracking & Claiming R&D for the Past 3 Years
“Don’t forget that you’re not limited to brand-new products, website functionality or software. The credit is also available for coming up with a new process. And you can look back three years to see if past projects qualify.” — Summit CPA Group
Once you determine if your project or activity qualifies, it’s time to track and calculate the actual dollar amount of your expenses. Obviously, it's always best to start at the beginning of a project and document as you go. However, if your R&D activities took place over the past three years, you can go back and amend prior tax filings to capture unclaimed tax credits. Documenting prior activities can be done using tools such as time studies or employee surveys.
So what do you track, and when do you stop? Usually, service-related costs focus mostly on wages: time spent brainstorming, analyzing requirements or feasibility, design review, technical meetings, testing, etc.…When you’re able to monetize your product (you’re selling it), you don’t get to claim the credit, so you can stop tracking costs. That is, unless you’re making major iterations that may qualify.
Curious how other shops are maximizing the R&D tax credit? Let us know, and we’ll see if we can connect you. And, of course, Summit CPA Group is a fantastic resource to talk through your tax or accounting questions.
This article is for informational purposes only, and doesn't constitute tax, accounting or legal advice. For advice on how the tax credit applies to your business and unique situation, consult a tax advisor, accountant or lawyer.